Tuesday, January 29, 2008

Interest Rate Cuts: Whose Lead is the Federal Reserve Following?

At this point, it is widely perceived that the Federal Reserve is cutting interest rates because the stock markets want rate cuts. The Fed's surprise 75 basis point cut last week came upon the heels of sharply falling stock markets in Asia and Europe. The U.S. and other stock markets have more or less stabilized since then, but only because there is an expectation of more rate cuts this week.

Since it seems pretty clear that market expectations are driving Fed rate cuts, it's worth asking what's driving the market. The Norman Rockwell version of the stock market consists of numerous freckle-faced investors, sitting at soda fountains sipping frappes and placing buy and sell orders. Their collective judgment arguably provides a measure of insight about the state of the economy. The prices these investors are willing to pay for stocks are based on their predictions of the future value of those stocks, which will be affected by their expectations of good or bad economic conditions. Dropping stock prices may reflect an expectation that the economy is in for a bad time. Is the Fed mistaken to consider the views of all these folks?

Now, let's look at the markets of the 21st Century. We have a derivative contract called a stock index future, which allows an investor to speculate in the future value of a stock index like the S&P 500 or the Nasdaq 100. Like any futures contract, stock index futures can be traded on margin (and quite a lot of it). The stock index futures markets and the stock market are inextricably tied together. Any firm that writes stock index futures contracts will likely be trading baskets of the underlying stocks to hedge its positions. Activity in the futures market can result in large bundles of buy and sell orders hitting the stock markets. Thus, the futures market can drive the stock markets. Witness the stock index futures liquidations done by Societe Generale a week and a half ago, after it discovered that a junior trader had made the wrong bets. These sales may have contributed to the down trend in the European stock markets that alarmed the Fed into making its 75 basis point cut.

The cart, therefore, can end up pulling the horse. Over the last two decades, trading in the financial markets has become increasingly a game for big institutional investors, and the futures markets have increasingly taken the lead from the stock markets. But the stock index futures market doesn't look anything like a Norman Rockwell painting. It's dominated by high tech trading firms that use computers to trade in ways that even many Wall Streeters find esoteric. These people are financial market pros. Mom and Pop, who would struggle to tell you what a 10-K is, don't mess around in the stock index futures market.

If the stock index futures market is driving the stock market, and the stock market is driving the Fed's interest rate cuts, then doesn't it begin to look like a small group of financial market pros is making the central bank do its bidding? The short term trading interests of these market insiders are not the same as the long term investment interests of the general public. When the Fed allows itself to react to short term market movements, which seems to have been the case recently, there's a chance it's serving the interests of a small group of well-capitalized traders who are tough and market-savvy enough to think that they can push around a central bank. (Type "Black Wednesday and British pound" into your favorite search engine for an example of how financial speculators can take on a central bank.)

The economic data as to the likelihood of recession is mixed and does not alone present a compelling case for dramatic interest rate cuts, especially after last week's 75 basis point theatrics. Perhaps the Fed could cobble together a case for further cuts this week. Whether or not it can, however, it is now saddled with the impression that its monetary policy is at the beck and call of the stock markets--and perhaps the short term trading interests of futures market speculators. This impression will prove costly to the central bank.

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